Battle of the Bonds

Government Policy Disrupts Bond Market

By nullifying bankruptcy law in the Chrysler bailout, President Obama harmed bondholders and increased the cost to unionized companies of raising funds from bond markets. To show this, let me first provide an example of how bankruptcy law works.

Imagine a firm owes bondholders more than it can pay. If the firm were to go into bankruptcy, its assets would be divided among its bondholders. But bondholders aren’t treated equally in bankruptcy. This company might have two classes of bonds. Those in the first class, let’s say, have higher priority and so are entitled to be repaid before the second class of bondholders gets anything.

So imagine that our firm’s bankruptcy will happen unless it builds a new factory — and that even with a new factory, the firm would still have a high likelihood of going under. Absent priority rules, it would be very difficult for the firm to sell bonds to finance the new factory because the potential bondholders probably wouldn’t be repaid. Consequently, investors would be willing to buy bonds only if they were to receive an extremely high interest rate.

But the firm might be able to borrow at low rates if new bondholders were guaranteed a high priority in bank-ruptcy. To keep everything simple, assume the firm has huge debts, no assets and wants to build a $10 million factory. The firm could sell $10 million of bonds and give new bondholders top priority. These bondholders would have the rights to the factory if the firm went bankrupt — and an excellent chance of getting back most of their investment. Existing bondholders would benefit because by building the new factory, the firm would have at least some chance of earning enough revenue to pay them.

Chrysler used priority to sell bonds when investors feared the automaker wouldn’t survive. It turns out that hedge funds held many of the high-priority Chrysler bonds, whereas the United Auto Workers union owned those with lower priority. Consequently, in a normal bankruptcy the hedge funds would have gotten back a much higher percentage of their investments than the UAW would have.

The Obama administration, however, felt this result would be unjust and pressured the hedge funds to “voluntarily” accept lower priority than the UAW possessed. A few funds tried to hold out for more than the federal government was offering, but because of the government’s tremendous power over the securities market, they acquiesced. Paradoxically, the importance of what happened is magnified by the relatively small sums involved.

As blogger Megan McArdle of The Atlantic writes: “I heard repeatedly from progressives, in the run-up to the bankruptcy case, that (hedge funds) were unreasonably holding out for a trivial improvement — about $500 million. But if it was so trivial, why didn’t the government just put the extra money in, rather than jeopardizing confidence in the bankruptcy system — and the creditworthiness of a large swathe of unionized firms? ... You know the answer, don’t you? Because they’re planning to do it again.”

The market values of existing high-priority bonds have fallen, almost certainly because of the new political realities in bankruptcy. And unionized companies will now get less when they sell bonds with high priority because investors will fear that priority might not be respected in bankruptcy.

James D. Miller is an associate professor of economics at Smith College in Northampton, Mass. His latest book is Singularity Rising: Sur­viv­ing and Thriving in a Smarter, Richer and More Dang­erous World (BenBella Books), on sale in October.